Why currency hedged ETFs are rising in popularity

We explain why hedging against volatile currency markets can be a good idea.

Currency hedged ETFs are a simple way for investors to protect themselves against currency risk.

When we invest in foreign assets, our total return equals the local market return plus or minus the performance of sterling versus the local currency. If the US equity market returns 5% but the dollar drops 6% against the pound then an unhedged UK investor takes a 1% loss. Why? Because dollar priced assets are now worth less when converted back to pounds.

If the pound rises against a foreign currency then your assets priced in that currency lose. If the pound falls then your foreign assets win. It’s the same principle as exchanging holiday money at the Bureau de Change.

But a currency hedged ETF is designed to minimise the currency effect. In our previous example, a fully hedged UK investor would earn approximately the 5% local return and can forget about the fickle hand of the currency markets. That’s useful for anyone who doesn’t like volatility and has become a live issue for many UK investors since the pound plunged in the wake of the Brexit vote.

GBP/USD since 2007

Source: ECB fixing; GBP/USD 02/01/2007 - 28/02/2017
That fall actually spelt good news for unhedged UK investors with plenty of dollar and euro priced assets. Suddenly those holdings bought a lot more in pounds and inflated the return to investors with bills to pay in the UK.

But currencies are known to mean-revert over time; leaving many investors to ponder whether the pound’s fall represents a new baseline, or are Brexit fears overblown? In the latter scenario, overseas assets could face a headwind as the pound rises against foreign currencies.

Nobody knows how events will unfold, but currency hedged ETFs can act as useful insurance against a rebounding pound for a proportion of a globally diversified investor’s portfolio.

More reasons to own a currency hedged ETF

You may want to own global equities in order to diversify beyond the UK but you could do without the risks of fluctuating currencies on top.

That’s especially relevant for older investors whose shorter time horizon makes them more vulnerable to risk. If you don’t have time to recover from the dent put into your returns by a rising pound over the course of five to ten years then a currency hedged ETF is the diversifying alternative to concentrating more of your holdings in UK assets.

Currency hedging also makes sense for investors whose portfolios are dominated by global assets. If you diversify in proportion to the geographic split of the global market then, as a UK investor, only 7% of your assets would be invested in home equities. The equivalent US investor would have over 50% of their portfolio invested at home and would be less vulnerable to negative currency moves.

Currency hedged ETFs enable investors to express their views on specific currencies too. For example, if you thought Abenomics was likely to stimulate Japan’s stock market in 2013 but also weaken the yen, then you could have moved into a pound-hedged Japan ETF. And, as it turned out, you would have been right as the iShares MSCI Japan GBP Hedged ETF returned 52% that year versus 23% for the unhedged version.

MSCI Japan ETFs in 2013 hedged and unhedged

Similarly, there’s some evidence to suggest that safe haven currencies are negatively correlated with global equity markets. If you anticipate good times ahead for world trade then you could hedge those currencies (e.g. the dollar) so that your US equity returns aren’t punished if the dollar slides.

How do currency hedged ETFs work?

The straightforward approach is to replace all or some of your allocation to an unhedged ETF with a pound-hedged version tracking the same region. For example, you could replace the db X-trackers S&P 500 ETF with the db X-trackers S&P 500 ETF (GBP hedged).

Often the two ETFs will feature the same components in the same proportions but the hedged version also contains the magic currency cancelling formula. Except that it’s not magic. It’s a short position taken against the foreign currency that benefits if that currency declines. Most ETFs use a hedge known as a forward currency contract. It’s an agreement to exchange two currencies at a fixed price and date - typically one-month or one-day ahead.

The forward contract matches the value of the ETF’s assets, so if your foreign investments fall in value against the pound, then the losses are offset by the contract’s gain.
Equally, if the foreign currency appreciates against the pound then those gains are negated by the contract’s loss.

Either way, you’re left with approximately the returns of the local market. Why approximately? Because no hedge is perfect. The asset value of the ETF fluctuates in tune with the market and so there can be a mismatch with the size of the hedge by the time the forward contract expires. If the hedge was bought to cover £10million worth of assets but they grow to £12million then you will be underhedged. The potential for tracking error is obviously greater for a hedge that resets monthly versus one that resets daily, but daily contracts can incur higher costs.

Hedging costs include the bid-offer spread between two currencies (think the difference between the buy and sell prices in the Bureau de Change), transaction costs and the cost of carry. The cost of carry is positive if the interest rate of the pound is higher than the foreign currency but negative if the reverse is true.

Emerging market currency spreads and interest rates are normally much higher than developed world equivalents which is why you won’t see any Emerging Market (GBP hedged) ETFs.

The extra costs of the hedge will often emerge in the Total Expense Ratio (TER). Many hedged ETFs are 0.1% pricier than their unhedged equivalents, which amounts to £10 difference on a £10,000 holding. Sometimes the gap is wider and occasionally there’s no extra expense at all.

What else should I watch out for?

Currency hedged ETFs are relatively new so do not typically have long performance records. Over time, you can use tracking difference between an ETF and its index return to check how effective the hedge is and how big a bite its costs are taking from your net returns. The more data you have the better, but it’s not worth making a call on less than three years returns.

Hedged ETFs are also pretty small at this stage - as measured in assets under management. That can be an indicator of higher transaction costs due to wider bid-offer spreads when you trade. Small ETFs can also be closed by management if they don’t scale sufficiently. You wouldn’t lose your money in that instance, but may incur costs from being out of the market or triggering capital gains tax events.

There’s less choice too, so you may not be able to choose precisely the index, country, or provider that you want, and competitive pressure on TERs won’t be as fierce.

That said, you can happily hedge out currency risk for all the major regions of the developed world now. The US, Europe and Japan are all reasonably well served as you can see below.

Use the ETF Screener to search for currency hedged ETFs - just look for the words "GBP Hedged" in the ETF’s name or use the currency hedge filter.